Presentation on Capital Asset Pricing Model

Presented by:Amit Singh PG-10-50006 Suchitra Singh PG-10-50040 Anurag Srivastava PG-10-50011 Amit Kumar s/o APS PG-10-50007 Aniket Kumar PG-10-50009

Origin of CAPM Model

Markowitz theory helps an investor to achieve his Optimal Portfolio Position. William Sharpe & others asked a follow-up Questions: What is the relationship between risk & return for an efficient portfolio. What is the relationship between risk & return for an individual security. The CAPM predicts the relationship between the risk of an Asset and its expected Return.

Origin of CAPM Model

The Relationship predicted by Sharpe and others in CAPM Model is useful in two ways:It produces the benchmark for evaluating various investment. It helps us to make an informed guess about the return that can be expected from an asset that has not yet been traded in the market.

Basic Assumptions
Individuals are risk Averse.
Individuals seek to maximize the expected utility of their portfolio over a single period planning horizon. Individuals have homogeneous expectations. Individuals can borrow and lend freely at a riskless rate of interest. The Market is Perfect. The quantity of risky securities in the market is given.

CAPM Formula
The formula for CAPM is:

r r f (rm r f )
where rf is the risk free rate rm is the expected return on the market and is the beta of the cash flows or security being valued.

Capital Market Line

For efficient portfolios (which include the market portfolio) the relationship between risk and return is depicted by the straight line Rf .

The equation for this line, called the capital market line (CML), is:

where, is the slope for CML may be regarded as the price of risk in the market.

E ( Rm) Rf m

Capital Market Line

CML
E(rP)

M
Rf

P
7

Security Market Line

The SML relationship says:
Expected return on security I = Risk free return + (price per unit of risk) Risk

E ( Rm) Rf The price per unit of Risk = 2m

Security Market Line: Risk/Return Trade-Off with CAPM

Expected Return

SML

Rf

Systematic risk

Relationship between SML and CML

CML relationship is a special case of the SML relationship.
As per the SML

Since,

iM iM i M

can be re-written as:

E ( Ri ) R f (

E ( Rm ) R f

) iM i

If the returns on i and M are perfectly correlated (this is true for efficient portfolios),then

E ( Ri ) R f (

E ( Rm ) R f

) i

Inputs Required for Applying CAPM

To apply the CAPM, the following factors that determine the CAPM line.

Risk Free Rate.

Market risk Premium

Beta.